Firms’ Investment Decisions and Interest Rates
Kevin Lane and Tom Rosewall*
Firms typically evaluate investment opportunities by calculating expected rates of return and
the payback period (the time taken to recoup the capital outlay). Liaison and survey evidence
indicate that Australian firms tend to require expected returns on capital expenditure to exceed
high ‘hurdle rates’ of return that are often well above the cost of capital and do not change very
often. In addition, many firms require the investment outlay to be recouped within a few years,
requiring even greater implied rates of return. As a consequence, the capital expenditure decisions
of many Australian firms are not directly sensitive to changes in interest rates. Furthermore,
although both the hurdle rate of return and the payback period offer an objective decision rule
on which to base expenditure decisions, the overall decision process is often highly subjective, so
that ‘animal spirits’ can play a significant role.
Graph 1
Introduction
In real terms, non-mining business investment in
Australia has been little changed for several years
(Graph 1). In nominal terms, it is at a low level as a
share of GDP compared with its history. Relatively low
levels of investment outside of the resources sector
was one of the ways in which the Australian economy
accommodated the unprecedented boom in
commodity prices and the associated strong increase
in mining investment over much of the past decade.
Mining investment peaked in mid 2012 and although
there has been modest growth of economic activity
in the non-mining sector in recent years, non-mining
business investment has remained subdued. Many
other advanced economies have also experienced
sustained weakness in business investment since the
late 2000s.
Several reasons have been put forward to explain the
ongoing weakness in business investment both here
and abroad, including weak demand, heightened
uncertainty and low business confidence.1 These
* The authors are from Economic Analysis Department.
1 See Kent (2014) for a discussion of the possible constraints on
non-mining business investment in Australia and IMF (2015) for a
discussion of subdued private investment activity across advanced
economies more generally.
Private Business Investment
Chain volume, log scale*
$b
$b
128
128
Non-mining
64
64
32
32
Mining
16
16
8
94 / 95
*
98 / 99
02 / 03
06 / 07
10 / 11
8
14 / 15
Reference year is 2012/13; RBA estimates for 2014/15 as at May
2015 Statement on Monetary Policy
Sources: ABS; RBA
themes also feature in discussions about firms’
investment intentions with contacts in the Bank’s
business liaison program.2 Moreover, many contacts
2 The Reserve Bank business liaison team conducts around 70–80
discussions with contacts on a monthly basis. Discussions with
individual firms occur around every 6 to 12 months, with Bank staff
usually meeting the chief executive officer, chief financial officer
and/ or operations manager. Liaison meetings are held with firms of
all sizes, although most discussions are with mid-sized and large firms
where conditions are somewhat more likely to reflect economy-wide
trends rather than firm-specific factors. For more information,
see RBA (2014).
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FIRM S ’ I NV ES T M ENT D E CI S I O N S A N D I N T E RE S T RAT E S
have reported that low interest rates do not directly
encourage investment. In contrast, economic theory
suggests that the rate of interest affects the cost of
capital and should influence investment decisions
directly, based on standard methods used to
evaluate investment opportunities.
Detailed discussions with business liaison contacts
reveal why lower interest rates might not have any
direct effect on investment, even at the margin.
Contacts indicate that required rates of return on
capital expenditure, also referred to as ‘hurdle rates’,
are often several percentage points above the cost
of capital. More importantly, contacts note that the
hurdle rate is often held constant through time,
rather than being adjusted in line with the cost of
capital. Regardless of whether changes in interest
rates have a direct effect on investment decisions,
interest rates will still have a powerful indirect
influence on firms’ investment decisions through
other channels, including their effect on aggregate
demand.
The Investment Decision
The appraisal process for capital expenditure usually
varies according to the objective of the investment
opportunity. Some capital expenditure may be
approved without the use of quantitative criteria,
particularly if it relates to maintenance, reducing
pollution, improving safety or security, or complying
with regulations. But, in general, discretionary capital
expenditure is subject to quantitative evaluation,
with the level of scrutiny determined by the size
of the investment, its perceived riskiness and
managers’ attitudes towards risk. Typical evaluation
methods used include discounted cash flow (DCF)
analysis and the payback period. Both methods
need an assessment of future cash flows that will
be generated by the investment. This requires a
range of inputs (e.g. projected sales, operating costs,
taxes, etc), many of which are uncertain. Businesses
typically use the most likely cash flows in each period,
though the expected value of cash flow, calculated
as a probability weighted average, is also used.
2
R ES ERV E BA NK OF AUS T RA L I A
Discounted cash flow analysis
DCF analysis is a standard method recommended by
finance theory to evaluate investment opportunities.
The method proposes that the investment decision
should be made with reference to the estimated
net present value (NPV ) of the opportunity, which
is the sum of all cash flows (CFt ) resulting from the
investment, discounted using the firm’s chosen
discount rate (i ):
N
NPV = ∑
t =0
CFt
(1+ i)t
(1)
In the simplest case, the firm should invest if the
NPV is positive for the chosen discount rate; put
differently, the project should be approved if the
internal rate of return of the project is above this
specific discount rate.3 Because it provides a natural
threshold to accept or reject investment decisions,
the discount rate used in DCF analysis is often called
the ‘hurdle rate’.
Theory suggests that the hurdle rate for a typical
investment should be set with some reference to
the firm’s weighted average cost of capital (WACC),
which includes the cost of both debt and equity.
For example, the level of the hurdle rate may be
greater than the WACC if the potential investment
has greater non-diversifiable risk than the overall
operations of the firm. The extent of such a gap
will also depend on the extent to which managers
and shareholders are averse to risk. Changes in
interest rates influence the cost of debt and, under
reasonable assumptions, the cost of equity, and so
should influence the hurdle rate.
Payback period
Firms may also evaluate investment decisions using
the payback period, which is simply the number
3 In practice, firms often have the option to defer investments to learn
more about the economic environment. The ability to wait can be
valuable because it may allow firms to avoid loss-making investments.
In this case, the simple NPV decision rule does not apply: the firm
should invest only when doing so provides returns in excess of the
sum of the outlay plus forgoing the option value of waiting. This line
of reasoning calls for the use of real options analysis; see Dixit and
Pindyck (1994).
F I RMS’ IN VE STME N T DE C ISIO N S AN D IN TE R E ST R ATE S
of years it would take for the capital outlay to be
returned by the cash flows generated by the project.
Although the payback period is intuitive and easy to
communicate, it does not take into account the time
value of money and ignores cash flows beyond the
chosen cut-off date.
Evidence from Australian Firms
A typical firm in the Bank’s liaison program evaluates
discretionary capital expenditure by using DCF
analysis, and also by considering the payback period
as a supporting consideration. This is in line with
the evidence from other advanced economies such
as the United States and the United Kingdom (see
below) and is also in line with earlier survey evidence
for Australia. For instance, a survey of Australian firms
conducted by academics in 2004 also found that the
vast majority of firms used both methods, which,
according to other surveys, had become more
popular over the preceding decades (Graph 2).
Graph 2
These observations are broadly in line with recent
evidence from the Deloitte CFO Survey, which found
that nearly 90 per cent of the Australian corporations
that responded used hurdle rates exceeding 10 per
cent, and around half of the corporations used a
hurdle rate exceeding 13 per cent (Deloitte 2014;
Graph 3). Liaison contacts reason that the hurdle
rate is often set above the cost of capital to account
for uncertainty about the cash flow projections.
Contacts also note that there is likely to be an
optimism bias in these cash flow projections. As a
result, setting a hurdle rate above the cost of capital
is likely to improve the chances that investments add
value to the firm on a risk-adjusted basis.4
Graph 3
Hurdle Rates
For investment decisions, share of firms*
%
%
40
40
30
30
20
20
10
10
Capital Budgeting at Australian Firms
%
Proportion of firms surveyed using each method
Discounted cash flow
Payback period
%
80
80
60
60
40
40
20
20
0
0<7
7<10
10<13
13<16
16
0
Hurdle rates – %
0
1979
1983
1989
1997
2004
0
Sources: Freeman and Hobbes (1991); Kester et al (1999); Lilleyman
(1984); McMahon (1981); Truong, Partington and Peat (2008)
Discounted cash flow analysis
Liaison contacts indicate that the hurdle rates used
to evaluate business investment opportunities are
often several percentage points above the WACC.
Hurdle rates of around 15 per cent are quite common,
though the range of rates reported is relatively wide,
from a little less than 10 per cent up to 30 per cent.
*
Excluding firms that do not use a hurdle rate
Sources: Deloitte CFO Survey; RBA
Many liaison contacts also report that hurdle rates
are not changed very often and in some instances
have not been altered for at least several years. These
observations are also reflected in the recent survey
by Deloitte; two-thirds of corporations indicated
their hurdle rate was updated less frequently than
their formal review of the WACC, and nearly half
reported the level of their hurdle rate was changed
‘very rarely’ (Graph 4). For these firms, changes in
4 Adjusting for risk by using a higher discount rate rather than by
probability weighting the cash flows introduces a bias against
longer-term projects, since the present value of a longer-dated cash
flow is more sensitive to changes in the discount rate.
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FIRM S ’ I NV ES T M ENT D E CI S I O N S A N D I N T E RE S T RAT E S
Graph 4
Frequency of Hurdle Rate Changes
Share of firms*
%
%
40
40
30
30
20
20
10
10
0
When WACC Less frequently Very rarely
is updated
than WACC
*
Never
0
Excluding firms that do not use a hurdle rate
Sources: Deloitte CFO Survey; RBA
interest rates do not flow through to hurdle rates;
rather, the margin between the WACC and the
hurdle rate changes. One-third of firms said they
update their hurdle rate when they review their
WACC, which is possibly on a quarterly or annual
basis; other contacts in the liaison program have
also noted the WACC used in investment decisions
is similarly reviewed infrequently.
Liaison contacts have provided several reasons why
the hurdle rate may not be sensitive to the cost of
capital. A common observation is that the true cost
of equity, and therefore the overall cost of capital,
cannot be observed.5 Managers have also noted
that changes in the observed cost of debt owing to
changes in interest rates are likely to be temporary,
and so they are reluctant to react to developments
that may soon be unwound. A few business contacts
have argued that keeping the hurdle rate constant
acts as an automatic time-varying risk adjustment:
interest rates tend to be low when uncertainty is high,
so the gap between the hurdle rate and the cost of
5 In general, managers of listed firms appear to use the capital asset
pricing model (CAPM) as their primary measure of the cost of equity.
Similar results have been found for US and European firms (Graham
and Harvey 2001; Brounen, de Jong and Koedijk 2004). As several
liaison contacts have noted, the cost of equity implied by CAPM will
be sensitive to the estimation sample period and method. In addition,
other measures of the cost of equity could provide different results.
4
R ES ERV E BA NK OF AUS T RA L I A
capital should be higher (and vice versa). There are
two additional reasons why the net present value
is not particularly sensitive to unit changes in the
hurdle rate. First, a unit change in the hurdle rate will
have less effect on the net present value when that
rate is set well above the cost of capital. Second, firms
often ignore cash flows that are some distance in the
future (say, beyond five years), and the present values
of these later cash flows are more interest sensitive.
For some firms, moving the hurdle rate by a
percentage point or more would be immaterial to
the decision process, since accepted investments
tend to have much higher returns. Many contacts
report that projects with a rate of return above the
hurdle rate were often rejected anyway. This may be
because the payback period was too long or because
of other considerations (see below). These reasons
suggest that managers might value the option to
defer an investment until its expected net present
value is greater. In the absence of more sophisticated
analysis, using a hurdle rate in excess of the WACC
may be a reasonable approach to account for this
option value of waiting (McDonald 2000).
Discussions with managers have shown that there
are several reasons why small changes in the cost of
capital may not warrant changes in a firm’s hurdle
rate. Some managers indicate that changes to the
hurdle rate may send the wrong message to staff
proposing projects about the overall risk tolerance
of the firm. Others indicate that changes in the
hurdle rate require board approval, which introduces
stickiness. However, in many instances it appears that
firms are using hurdle rates that have not changed in
a long time, set at a time when nominal long-term
interest rates were far higher than they are today.
Whether explicit or not, such behaviour is consistent
with a reduced appetite for risk or the possibility that
risks have increased.
Payback period
The payback period is used extensively by firms in
Australia. In liaison, the most common payback
period reported by contacts is three years, though
F I RMS’ IN VE STME N T DE C ISIO N S AN D IN TE R E ST R ATE S
not all contacts that use the method use a fixed value.
Some firms have reported a period of less than three
years for at least some types of capital expenditure,
including target periods of 12 months, implying very
high required rates of return for a given capital outlay.
In some cases, firms have reduced their maximum
payback period in recent years. Contacts often
report using the payback period in conjunction with
DCF analysis and smaller firms sometimes rely on the
payback method exclusively.
Liaison contacts cite various reasons for using the
payback period, despite its theoretical shortcomings,
in addition to DCF analysis:
••
Firms place a premium on recouping cash.
In liaison, this reason has been used by both
financially constrained and unconstrained firms.
For example, strongly performing firms have
explained that they use the payback period to help
ensure that they retain their high credit rating.6
••
There is greater uncertainty around cash flows
that are further into the future.7
••
The cash flow forecasts used by project
proponents in DCF analysis are often considered
to be optimistic by their managers. In effect,
the payback period adds another buffer to
the hurdle rate to increase the likelihood that
investment projects generate a return in excess
of the cost of capital.
••
There are more projects with expected returns
exceeding the notional hurdle rate than the
firm wishes to pursue. Firms view the payback
period as an efficient method to screen projects,
especially when the ultimate decision-maker
in the firm has less information than those
proposing the project.
Other considerations
It is clear from discussions with managers that the
overall investment decision process is often highly
subjective, introducing a role for ‘animal spirits’ or
‘gut feeling’ to have an important effect on capital
expenditure decisions. This is not surprising, given
that future cash flows generated for the quantitative
criteria discussed are often difficult to forecast
and hence rely on subjective input from project
proponents. However, many contacts have reported
that projects satisfying quantitative criteria have
been rejected anyway because of other constraints,
including strategic considerations, heightened risk
aversion, a restricted capital budget imposed by
higher levels of management or the global parent
company, limited resources to deploy projects or
shareholder perceptions.
Evidence from Other Advanced
Economies
The available evidence suggests that firms in
other advanced economies undertake investment
decisions using similar criteria employed by
Australian firms. Surveys have found that firms in the
United States and Europe tend to evaluate proposed
investments using discounted cash flow techniques,
which have become more popular over the past few
decades, and the payback period.8
Studies of firms overseas have found that they also
use hurdle rates that are above their cost of capital.
Jagannathan, Meier and Tarhan (2011) surveyed
firms in the United States in 2003 and found that a
typical firm used a hurdle rate several percentage
points above its WACC. Brunzell, Liljeblom and
Vaihekoski (2013) found a similar result for Nordic
firms. Similarly, firms in other countries also appear
to use hurdle rates that are not sensitive to the cost
6 In a large-scale survey of US chief financial officers, Graham and
Harvey (2001) found the firm’s credit ratings to be a chief concern.
Graham and Harvey also found no evidence that use of the payback
period was related to a firm’s financial position or performance.
7 Although, under DCF analysis, greater uncertainty around cash flows
that are further into the future is accounted for, at least in part, by the
greater effect of discounting on these cash flows.
8 See Graham and Harvey (2001) for a discussion of North American
firms and Brounen et al (2004) for a study of European firms.
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FIRM S ’ I NV ES T M ENT D E CI S I O N S A N D I N T E RE S T RAT E S
of capital.9 Sharpe and Suarez (2013) drew on several
surveys to conclude that the average hurdle rate of
US firms has not changed since the mid 1980s, even
though there has been a marked decline in
long-term nominal interest rates over the past three
decades.
Several surveys have confirmed that the payback
period remains popular among firms in other
advanced economies. As in Australia, a payback
period of around three years is common for firms
in the United States and the United Kingdom
(Lefley 1996).
Implications for Business
Investment
Analysis of the investment decision process helps
to explain the subdued growth of non-mining
business investment. First, there is some evidence of
a tightening in investment criteria since the global
financial crisis. For example, some firms have reduced
their maximum payback period, suggesting implied
discount rates for investment decisions may have
increased even as long-term interest rates declined.
Second, identifying investment opportunities with
returns exceeding the typical hurdle rate of around
15 per cent may be difficult for many firms given
their expectations for the growth of their sales.
It is clear from discussions with liaison contacts that
the overall decision process is highly subjective,
which in turn allows ‘animal spirits’ to play a role. As
noted, firms frequently reject investment decisions
that satisfy self-imposed quantitative criteria
on other grounds, such as concerns about the
economic outlook, the availability of capital within
the company, or shareholders’ preferences. Some
managers have noted that they have taken a more
cautious approach to capital expenditure since
the financial crisis, either because there is more
uncertainty about the future or they are more averse
9 The phenomenon of firms using very high hurdle rates was noted
even earlier by Shackle (1946), following a series of interviews with
business managers conducted by the Oxford Economists’ Research
Group: see Besomi (1998).
6
R ES ERV E BA NK OF AUS T RA L I A
to taking risks. As a consequence, firms with a range
of opportunities may only be willing to pursue the
most profitable projects in the current economic
environment.
Although changes in interest rates may not have
a direct effect on investment decisions for many
firms, interest rates will still have a powerful indirect
influence on firms’ investment decisions. For
example, a reduction in interest rates may improve
firms’ cash flows through reductions in interest
payments, freeing up cash for other purposes. More
broadly, interest rates affect economic activity via
a number of channels, including the saving and
spending behaviour of households, the supply
of credit, asset prices and the exchange rate, all of
which affect the level of aggregate demand.
Conclusion
Contacts in the Bank’s business liaison program have
reported a range of reasons for the subdued level
of non-mining investment, though they typically
state that low interest rates do not by themselves
encourage investment. Detailed discussions with
managers and survey evidence indicate that the lack
of direct interest rate sensitivity partly arises because
Australian firms typically use effective discount
rates that are high and sticky to evaluate capital
expenditure opportunities. This reflects the use of
hurdle rates that are considerably higher than the
weighted average cost of capital and are adjusted
infrequently, or a requirement that any outlay must
be expected to be recouped within a few years. R
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